Small cap prophets: A profit season guide

We ask five experts their small caps earnings views ahead of the upcoming reporting season.

Summary: Business conditions across the small caps sector have been tough for many, but not all. Some industries remain under intense pressure, yet there are reasons to be positive in others. Today we speak to five small caps experts to get their predictions ahead of the upcoming earnings reporting season, and they also give us their top stock picks.
Key take-out: The small caps experts predict that reported sales growth levels will be flat, or lower, in the next round of earnings results due the underlying weakness in economic conditions. Mining services companies will likely stand out, but for all the wrong reasons.
Key beneficiaries: General investors. Category: Shares.

Tomorrow marks the official start of the full-year reporting season and there’s a high wall of worry for small cap investors to scale given the unhealthy mix of economic and political uncertainties that lie on our immediate horizon.

What’s worse is that views on this reporting season vary widely, with a number of experts warning that earnings are likely to miss their mark as companies struggle to hold their own against high costs, volatile commodity prices, big swings in the exchange rate and poor business and consumer confidence.

Feeling nervous yet? I won’t blame you, as the uncertain outlook for the market is likely to persist for most of the first-half of the current financial year.

While it might not bring total comfort, I posed three key questions to a roundtable of leading small cap fund managers in the hope that it will help investors navigate what could turn out to be a treacherous reporting season.

The fund managers are Sandy Grant from WilsonHTM Priority Growth Fund, Jeremy Bendeich from Avoca Investment Management, Ed Prendergast from Pengana Capital, ST Wong from Prime Value Asset Management, and Carlos Gil from Microequities.
Graph for Small cap prophets: A profit season guide

Q1: What are you expecting in the August reporting season?

Grant: We expect a fairly subdued reporting season for small companies, but given the relatively high valuation multiples attached to many companies, there is scope for some share price declines despite many companies already giving earnings guidance.

In a similar manner to the share price performance of the past two years, the gap between the good companies with a clearly defined strategy that is being well executed and other companies that have no sustainable competitive advantage is likely to be vast.

Generally speaking, we continue to favour the industrial small companies relative to the small miners with little strategic or cost advantage.

Bendeich: We expect that earnings for cyclical companies will have deteriorated in the last quarter of FY13, as the economy noticeably softened. Small cap stocks that are highly leveraged to this are discretionary retail, and industrial services. Given continuous disclosure requirements, the key risks will be around the FY14 outlook statements.

The RBA will cut interest rates and in 12 months the rate of decline in economic growth should bottom out and Australia will grow, albeit at a slower pace. As a result, we will be watching for quality names that get oversold this reporting season.

In aggregate, FY14 consensus earnings growth looks high given governments have to reduce spending and increase taxes, and consumers will not respond until employment stabilises.

Prendergast: Market forecasts for small caps are potentially too high in sectors such as retail and media where consumer and business confidence has not recovered, hence draining the rate of recovery already baked into forecasts.

Also, companies exposed to business spending are likely to provide poor outlook statements given anecdotal feedback regarding corporate spending.

Wong: The probability of disappointment should be reasonably low, on the back of investors selling down the obvious sectors and ongoing profit downgrade disclosures.

In addition, investor expectations should be somewhat more subdued as the macro backdrop has softened. There may still be room for disappointment from write-downs impacting, say in the junior miners segment.

In addition, the continuing downgrades amongst mining services companies could still throw up negative surprises.

Gil: The recent share price rises in many small cap companies needs to be validated by a rise in earnings, otherwise this could plausibly lead to downward pressure on market prices.

I think industrial businesses not exposed directly or indirectly to resources are also going to have a challenge to deliver strong growth. However, one of the benefits of some selected small companies is they do have the ability to grow irrespective of the prevailing macroeconomic environment.

Q2: What are some of the key things you will be watching out for in the results?

Grant: We are forecasting modest sales growth figures for the last half across most companies given an uncertain political environment and low consumer confidence restricting sales growth. Clearly mining companies, especially the mining service companies, are likely to report sustainably lower revenues for the last six months of the year.

One of the more interesting features of this reporting season will be the attitude of auditors and company directors to asset values. Following the decline in returns from many businesses there will potentially be pressure on some companies to make adjustments to some of the carrying values of some of the assets on their balance sheets. Although these balance sheet adjustments are non-cash items, there will nonetheless be pressure on some of these companies to potentially raise equity to repair their financial position.

Bendeich: Revenue growth will be hard to come by given weak economic conditions. Margins will likely come under pressure in this environment, especially for importers who have had a free kick from a high Australian dollar.

The mining services sector will continue to experience increased margin compression as excess demand flips into excess supply. This will impact revenue growth and margins. In addition, working capital requirements will increase as customers demand better terms.

Prendergast: Mining services is likely to be the source of further disappointment. Notwithstanding the slew of downgrades over the past six to nine months, we still expect further downward adjustment to expectations based on lower revenues and tighter margins.

As witnessed by the sharp correction in Ausenco’s price following its downgrade this week, the market is clearly still adjusting to the worsening environment. Hence arguing that it is already “in the price” is bold.

Wong: I have segmented my analysis to two key segments – stocks that have outperformed year-to-date, asking the question of whether they will continue to do well; and the underperformers – is there value to be found?

Best performers year-to-date include three key sectors: consumer discretionary (including online companies), diversified financial services and junior telco companies. I will be focussing on the companies’ ability to sustain and improve profitability through demand growth and their ability to price against the backdrop of slower economic growth, the employment picture deteriorating and interest rates cuts that have yet to bite in a meaningful way.

On the downside, the worst performers year-to-date squarely include junior mining companies and mining services companies. Mining services clearly continues to be under pressure, and therefore I am looking for managements’ responses to managing the difficult outlook and the state of cash flows and balance sheets.

Gil: In each company we observe a softer set of KPIs (key performance indicators) for management. Generally, earnings quality is always important, so we’ll be keeping a close eye on metrics like operational margins including gross and EBITDA (earnings before interest, tax, depreciation and amortisation) margins.

Q3: Which small cap stock(s) do you think will surprise on the upside or downside?

Grant: Companies with strong structural growth stories and competitive advantages are likely to post strong revenue gains. Included in this group would be Titan Energy Services (TTN), Silver Chef (SIV), Slater and Gordon (SGH), Drillsearch Energy (DLS) and NEXTDC (NXT).

Fund Managers' Picks

Stocks that may surprise on upsideFM*Est FY14 P/E (x)Total 1-yr rtn (%)Market Cap ($m)Industry
Titan Energy Services SG5.45364.0392.57Oil & Gas Drilling
Silver Chef SG/JB15.73144.97229.81Trading Companies & Distribution
BT Investment Management SW15.12120.601,017.85Asset Management & Custody
Henderson GroupSW12.22103.513,096.87Asset Management & Custody
M2 Telecommunications Group EP13.9297.401,083.07Integrated Telecommunication Services
Slater & Gordon SG11.8369.27629.61Specialised Consumer Services
Amcom Telecommunications EP18.0760.78446.32Alternative Carriers
Austbrokers Holdings JB17.6457.27630.92Insurance Brokers
NEXTDC SGn.a33.00471.49Alternative Carriers
Vocus Communications 14.2423.13168.88Alternative Carriers
Drillsearch Energy SG7.048.53520.79Oil & Gas Exploration & Production
Stocks that may surprise on downsideFM*Est FY14 P/E (x)Total 1-yr rtn (%)Market Cap ($m)Industry
Specialty Fashion Group CG9.6891.31173.01Apparel Retail
Pacific Brands SW10.0364.20732.61Distributors
Gazal Corp CGn.a52.77147.77Apparel, Accessories & Luxury
Domino's Pizza Enterprises JB22.4131.84795.98Restaurants
OrotonGroup SW16.270.86299.25Apparel Retail
SAI Global JB15.00-10.59794.92Research and Consulting Services
Noni B CGn.a-11.3719.90Apparel Retail
APN News & Media SW4.10-43.77189.86Publishing
*Fund Manager - SG = Sandy Grant, JB = Jeremy Bendeich, EP = Ed Prendergast, SW = ST Wong, CG = Carlos Gil

Although there have been a number of the mining service companies have indicated that revenue growth has declined sharply in the second half, there may still be some disappointing revenue figures in this area of the market.

Bendeich: Two stocks that may positively surprise are Austbrokers Holdings (AUB) and Silver Chef (SIV). Austbrokers’ recent acquisitions and premium rises may contribute more than expected to FY13/14 numbers.

Silver Chef’s growing customer base, cafes and restaurants make it the fastest growing segment of retail, and their Go Getta product is gaining traction which could lead to another positive FY14 year.

On the other hand, Domino’s Pizza Enterprises (DMP), trading on a high price-earnings (P/E) multiple, is vulnerable to further weakening in economic activity in both France and even in Australia – as McDonald’s recent trading update suggested.

SAI Global (SAI) may experience continued organic revenue growth pressure, and with no recent acquisitions, FY14 growth of 10% in earnings before interest, tax, depreciation and amortisation (EBITDA) could be stretched.

Prendergast: My tips for positive surprises are M2 Telecommunications Group (MTU) and Amcom Telecommunications (AMM).

M2 is positioned to show solid earnings growth driven by the benefits of the Primus and Dodo acquisitions, plus a resumption of organic growth in its core SME operations. The defensive nature of its revenue streams insulates it somewhat from economic volatility.

Amcom is expected to continue its 20% earnings growth rate driven by further expansion in its fibre network in the Western Australia market. The move into cloud-based services provides a faster growing adjunct to its traditional offering.

Wong: In terms of small cap companies that could surprise, the diversified financials might be a possible area that could surprise positively. Companies such as BT Investment Management (BTT) and Henderson Group (HGG) could post better margins and increase dividend payouts.

Consumer discretionary companies that have been bid up on account of interest rates making an impact on consumer spending may warrant some caution. The top-line growth outlook may be anaemic, whilst margins could be weaker than expected. Examples include OrotonGroup (ORL), APN News and Media (APN) and Pacific Brands (PBG).

Gil: We expect Vocus Communications (VOC) to deliver strong organic growth. If you look across the telco sector, including large companies like Telstra (TLS), M2 Telecommunications (MTU) and iiNet (IIN), the sector lacks true underlying organic growth and most of the growth from the larger players is acquisitive-based growth.

Vocus is an exception. We expect the business to continue to deliver fast organic growth, particularly in its fibre optic services business.

In terms of downside risks potential, we are not seeing any evidence of any marked improvement in Australian retailing conditions. So, for retailers, we would be wary of any short-term expectations to the contrary. Therefore, our expectations for companies like Noni B (NBL), Specialty Fashion Group (SFH) and Gazal Corporation (GZL) are tamed.

Uncapped 100

Small cap stocks covered by the Uncapped team
CodeNameRationaleMarket cap ($m)Total return 1-year (%)Sector (GICS)
MTU M2 Telecommunications Group Amazing growth story and well run company. High free float and strong insto support.1,112101.35Financials
NHF NIB Holdings /AustraliaOnly listed health insurer. Widely held. Good performer.99251.69Information Technology
BRG Breville Group Well covered but good candidate for core holding due to good track record.97163.62Industrials
ARP ARB Corp Well covered but good candidate for core holding due to quality management.96543.22Industrials
MRM Mermaid Marine Australia Its strategically located facility on WA coast gives it a key advantage over competition in servicing Gorgon & Pluto projects.90054.41Health Care
GEM G8 Education Only listed childcare operator. Acquisition strategy paying off with stock delivering solid gains.731193.81Information Technology
AAD Ardent Leisure GroupWidely held stock. Earnings more defensive than anticipated. Good yield. Potential core holding.69843.97Telecommunication Services
SRX Sirtex Medical A shining star in the biotech space and one of the best performing stocks in 2012. Great product (liver cancer treatment) and bright outlook.69496.94Industrials
SGN STW Communications Group One of few companies able to benefit from online shift. Widely held and good insto support.65886.91Materials
AUB Austbrokers Holdings The insurance broker is a strong performer. Widely held and well liked by small cap investors.64056.39Consumer Discretionary
MMS McMillan Shakespeare One of the best performers since the GFC, but change to FBT rules is threatening growth.612-28.19Consumer Discretionary
BDR Beadell Resources Will be a very big FY14 for miner as it has to prove it aims to produce 200,000 ounces of gold a year.58914.12Materials
ACR Acrux One of the most successful Australian biotechs in recent history. Widely held by instos.563-8.81Financials
RFG Retail Food Group Owns a number of well know franchise brands. Widely followed by instos.54369.68Industrials
CCV Cash Converters International Strong performance is attracting investors. It's Australia's only listed pawn shop and pay day lender.49468.11Industrials
SEA Sundance Energy Australia Analysts have a favorable take on the oil & gas explorer, but stock is still under radar of most. Sundance provides exposure to prospective Eagle Ford shale.482148.21Health Care
NXT NEXTDC The cloud computing company is an IT sector darling. Fairly widely held and followed.47734.5Industrials
BRU Buru Energy Substantial size but not often covered by press. Widely held with good insto support.473-49.41Information Technology
AMM Amcom Telecommunications Well covered junior telco but good candidate for core holding.45664.3Industrials
CCP Credit Corp Group Strong price run attracted good investor interest. Leveraged to any rise in loan defaults. Not well covered by press.43452.02Financials
SLX Silex Systems Its uranium enrichment technology could become one of Australia's best innovations given its potential to change the nuclear power industry.431-34.46Consumer Staples
TOX Tox Free Solutions Widely held stock in the waste solutions business. Its unique because it operates in a defensive-growth niche.42831.13Industrials
BGA Bega Cheese Corporate interest in Australian food companies makes the cheese maker worth following.42189.74Health Care
HZN Horizon Oil One of better regarded small energy stocks that doesn't receive much media attention.42034.55Information Technology
CWP Cedar Woods Properties Property developer with good ROE and earnings growth track record.41561.99Consumer Discretionary
MYS MyState Well regarded and could make good alternative to bank stocks. Has good yield and earnings growth over past few years.39747.78Energy
FGE Forge Group One of the better performers in its industry. Good track record and potential core holding.3826.52Consumer Discretionary
UXC UXC Company has turned corner and enjoyed re-rating. What's next?34884.32Energy
RKN Reckon Fierce competition for cloud base accounting software puts it in firing line.32020.43Telecommunication Services
MYX Mayne Pharma Group Sizeable generic drug maker with interesting board members.318101.79Industrials
TGA Thorn Group One of few retail stocks that is performing well. The Radio Rentals chain owner is also well supported by instos.31639.72Financials
RCR RCR Tomlinson Good first half FY13 result and outlook, but will its fortunes change this year with the mining capex slowdown?31447.21Energy
UNS Unilife CorpThe developer of one-use prefilled syringes is close to an inflection point as the market is expecting the company to announce a major contract with a pharmaceutical giant in the coming weeks.3091.89Health Care
MOC Mortgage Choice Has a good track record and is leveraged to any housing recovery. The stock is also liquid with good insto support.29578.05Consumer Discretionary
NWH NRW Holdings One of the better regarded mining & civil contractors with good track record in delivering on projects.276-62.67Financials
SPL Starpharma Holdings Noteworthy for its good pipeline of innovations. Well run, widely followed.271-34.81Financials
RIC Ridley Corp High corporate interest in the sector and the shrinking pool of agri listed stocks make Ridley worth following.265-5.9Consumer Discretionary
AEU Australian Education TrustWell performing childcare centre property owner. Good yield story and outlook. 25951.76Health Care
GID GI Dynamics IncLargely forgotten by investors but could attract attention this year as it looks to gain US approval to use its intestinal shealth on diabetics.258-22.11Consumer Discretionary
MXI MaxiTRANS Industries Transport equipment maker posted good interim result. Has appealing yield and growth.236105.82Information Technology
AJA Astro Japan Property GroupStrong leverage to Japanese economy makes this an interesting stock to watch.23330.96Telecommunication Services
SIV Silver Chef Strong jump in the share price of the equipment financing group has attracted a good following.231143.38Consumer Staples
IMF IMF Australia Litigation funder is unique stock. Stock not liquid but its outlook appears promising given the number of potential class action lawsuits.22729.34Consumer Discretionary
CLH Collection House In similar space as Credit Corp. Strong stock performance has attracted a following and the stock appears to be well placed to run further219144.36Financials
GXL Greencross Acquisitive vetinary group. Good profit growth and share price performance, but gets little press.212143.52Energy
SHV Select Harvests Noteworthy for turbulent past and exposure to soft commodity market.210192.16Telecommunication Services
BNO Bionomics One of the larger cancer treatment developers in this market.206101.18Materials
DWS DWS Will be a big beneficiary if governments start spending on IT again.2036.69Industrials
NAN Nanosonics A successful medical tech story. Should be close to turning in maiden profit with its disinfection device.19647.06Consumer Discretionary
NWT Newsat Potential large cap if it can launch its own satellite in 2015.194-28.71Health Care
IPP iProperty Group Worth watching as it is trying to be the REA Group of Asia.19012.9Health Care
PFL Patties Foods Illiquid stock but has suite of well recognised consumer brands. Defensive yield.188-11.45Information Technology
WBB Wide Bay Australia The building society is trying to turn its fortunes around. Also worth watching for its exposure to Queensland housing market, particularly around major resource projects.187-20.43Materials
DTL Data#3 Well respected IT company that receives little press coverage.1857.62Consumer Discretionary
GXY Galaxy Resources Good upside potential if it can get its problem-prone Jiangsu plant back on track. Won't be easy to right this ship.177n.aConsumer Staples
SFH Specialty Fashion Group In early stages of turnaround. Can the women's apparel retailer sustain the momentum?17282.63Industrials
VOC Vocus Communications Telecom stocks are in favour but Vocus is one of the least covered17125.21Consumer Discretionary
IFM Infomedia Interesting tech play in the car parts market. Strong share price gain but gets little air play.170191.75Industrials
IMD Imdex Drilling company is well supported by instos and should benefit from any rebound in exploration activity.163-48.72Materials
CKF Collins Foods One of the few food franchise listed companies.16359.45Information Technology
MLB Melbourne IT A perennial underperformer could be interesting turnaround story as management is in midst of restructuring the business.15628.96Information Technology
HSN Hansen Technologies Operates in a high potential/growth industry but is not covered by press or brokers.1516.61Materials
RCG RCG Corp The footwear retailer is one of the best performing consumer stocks as online competition is not a big threat. Company has a good yield as well.14567.74Health Care
TFC TFS Corp The sandalwood products company offers exposure to both the agri and cosmetics industry. It will start commercial harvest this year.13414.29Telecommunication Services
TGS Tiger Resources Future lies in its Kipoi copper mine expansion in the Congo but miner is fully funded with DRC govt holding 40% stake in tenement. Next 12mths will be interesting.132-32.76Information Technology
UBI Universal Biosensors IncWell regarded biotech and one of few that's successfully manufacturing in Australia. Struck deal with a few global medical companies.13125Financials
MCP McPherson's The personal care and household products supplier had been relatively insulated from volatile discretionary spend and online threat, but its latest profit warning shows it's not immune.131-8.29Materials
REX Regional Express Holdings Well run airline that is overshadowed by Virgin and Qantas.1286.28Health Care
AZZ Antares Energy Liquid with good insto support. Already in production with exploration upside in Texas.12011.9Health Care
ACL Alchemia /AustraliaOne of the few biotechs with revenue stream. Good pipeline of oncology treatments.117-27.27Information Technology
POH Phosphagenics Sizable biotech with a game changing FY14 year ahead. Good insto following but questions of poor audit and governance standard could dog company.112-21.43Industrials
AMA AMA Group Good turnaround story but under the automotive services group is radar of most.108132.07Materials
NEA Nearmap A stellar performer with an Interesting business that offers high quality ariel maps to companies & government.107842.86Health Care
LCM LogiCamms Strong price performance and reasonable valuation attracting interest.10548.47Health Care
ESV Eservglobal Mobile money transfer company that has been gaining traction. Widely held by instos but low press coverage103118.42Information Technology
BGL BigAir Group The wireless microcap has gained strong following over past year or two but is often overlooked by investors and the press.9655.36Consumer Staples
SAR Saracen Mineral Holdings Emerging gold producer that is widely held by instos. Hitting milestones and looks cheap. Key asset is close to gold majors, which makes it a potential takeover target.95-66.67Industrials
DRM Doray Minerals Widely held by instos. One of the more favored gold explorers by brokers.91-14.34Consumer Discretionary
JIN Jumbo Interactive Innovative small cap facing off industry dominated by giants. Worth watching to see if it can carve out a profitable global business.8978.76Consumer Staples
CLV Clover Corp One of the star performers in 2012. Operates in growing but relatively stable niche.8940.58Health Care
PEN Peninsula Energy Widely held by instos and large free float. It's the only uranium miner on the list.83-6.67Consumer Discretionary
AOH Altona Mining Noteworthy copper play with Xstrata pullout of Roseby project in Australia and the good ramp up of its Finnish project.74-48.15Information Technology
CUV Clinuvel Pharmaceuticals Interesting skin disorder treatment developer that has done reasonably well over past year7314.46Telecommunication Services
RUL RungePincockMinarco IT company to resource industry. Facing tough operating climate with new CEO trying to restructure and turnaround company.7248.41Materials
WDS WDS Widely held with strong insto support. Engineering contractor diversified across mining, energy and infrastructure.65-0.95Materials
TAN  Tandou The only direct equity exposure to cotton prices. Also trades water rights and receives little press.6423.52Health Care
CAA Capral An aluminium manufacturer that is actually holding up relatively well given that manufacturing is on the nose. 636.67Industrials
CKL Colorpak The small cap packaging company has grown via acquisitions over past few years.6252.82Financials
BOL Boom Logistics Crane hire group is riding out the downturn in construction.  It's widely held by instos and is very liquid.61-48Industrials
TSM ThinkSmart Potential turnaround story worth keeping eye on.5681.58Information Technology
LGD Legend Corp Electronic parts supplier to utilities and other industries. Stable earnings with good yield. Often overlooked.54-18.25Materials
KOV Korvest The construction products and services supplier has been hit by project delays and deferrals. But its relatively high yield could give it some support.5318.26Information Technology
UML Unity Mining Growing Tassie gold producer with high free float. Valuation looks compelling too.51-30.48Materials
YTC YTC Resources Next 12-mths will be eventful after YTC secured funding for its projects from Glencore.47-5.26Consumer Discretionary
ISS ISS Group Good turnaround story from 2012 but the resource industry software developer under the radar of most. ISS has received a takeover offer after its inclusion in the Uncapped 100.4485.11Consumer Discretionary
OTH Onthehouse Holdings Alternative small cap to online property leader REA Group. It is trying to use more timely housing data as a compeitive edge against REA.4114.64Materials
NTC NetComm Wireless Under appreciated small IT hardware maker that is punching above its weight. Hardly covered by press.33121.74Materials
EBT eBet Potential alternative to star performer Ainsworth Tech. Has exclusive deal with US poker machine maker WMS.27148.61Health Care
MBO Mobilarm Unique product that could change global maritime safety practices with its man-overboard location beacon.18185.71Consumer Discretionary
PGC Paragon Care Emerging hospital equipment supplier that has been ignored by market.1575Information Technology
Source: Eureka Report, Bloomberg

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